Why Investors Are Buzzing About Luckin

SMITH BRAIN TRUST – Luckin Coffee, a China-based internet start-up coffee chain, had a particularly good financial reporting in third quarter, which had us pouring a cup and talking about the coffee-shop landscape with Maryland Smith’s Brent Goldfarb.

Goldfarb is an associate professor and the academic director of the Dingman Center for Entrepreneurship – and co-author with faculty colleague David A. Kirsch of Bubbles and Crashes: The Boom and Bust of Technological Innovation.

Q: The chain, which went public in the United States in May, has seen surging growth – and continued losses. The two-year-old coffee chain now has 3,680 stores, up from 1,189 last year, with some 9.3 million monthly transacting customers, up from 1.9 million, according to its most recent quarterly report. Revenue was up more than sixfold from the year-earlier period. However, the chain’s losses have continued to widen. Is this cause for worry? Or cause for optimism?

A: This is a traditional business. They are selling coffee, and I don't see this as a tech company. For example, I'm not convinced that using artificial intelligence (AI) for operations is a meaningful way to create sufficient efficiencies to sustain current prices. At the end of the day, they will have to raise prices. It then becomes a question of how much demand will fall. The elasticity of demand is the key question, and how much they will need to raise prices.

Q: Luckin has positioned itself as a rival to Starbucks from its earliest days. Do you think the Beijing-based coffee and tea chain can upend its larger rival?

A: Upend? No. Starbucks may have to respond, but I'm not sure I see a threat to Starbucks in China. Starbucks in China are upscale, nice spaces. That is part of the product. One would also have to ask if Luckin is creating more coffee drinkers rather than simply taking Starbucks’ customers.

Q: For all the good news in Luckin’s recent earnings report, the company’s losses continued to widen, to 531.9 million yuan from the year-earlier 484.9 million yuan. Investors, however, seemed focused on the good news. Why is Luckin so popular on Wall Street, despite its continued losses?

A: There are enough investors who believe that this growth can be converted into profits, or at least, greater fools will believe so. It's a great narrative – the market is very large, and growth is really astounding. The one thing we've learned with these sorts of ‘Get Big Fast’ strategies is that a lot has to go right for companies to turn a profit. And, fundamentally, there have to be sufficient scale economies to sustain the current pricing, or sufficient market entrenchment to allow higher prices. If they were able to show us the unit economics in individual stores, or profitability in individual stores, that would be very helpful in assessing Luckin's strategy. This would have to be coupled with lower unit costs generated by scale economies in coffee procurement and processing. It is possible for Luckin to make clear statements based on the data they have as to what would need to be true for sustained profitability. If they haven't, this is not a good sign. Generally, when companies choose less transparency, it is not a good sign. For example, even with highly secretive Apple, most investors have a good sense of their unit economics.

Q: Part of the Luckin startup’s appeal has been in the price of its coffee, with heavy subsidies creating price points that were below Starbucks’. Analysts have pointed to Luckin’s use of price subsidies as fueling its rapid expansion, worrying investors who see that formula as unsustainable. However, the company’s most-recent quarterly earnings do show slowing net losses. In your opinion, might that reflect an improving cost-control strategy? What should investors look for now, as they consider Luckin’s future?

A: What happens to demand as prices rise? To the extent that Starbucks reports on its China operations, we might see this as a baseline. It is not as if Starbucks did not face competition in China before Luckin – so understanding their top and bottom lines by store would be helpful. We should not expect that Luckin can achieve a radically different cost structure. Again, at the end of the day, prices will have to rise for profitability. That does not imply that investors will necessarily lose money, but it is a very risky stock.

Q: Looking forward, what do you see as the key trends in China’s coffee industry? Can internet-startup coffee shops and their traditional counterparts coexist?

A: Yes. The counter to this would be if there was a reduced value in actually going and sitting in public spaces such as coffee shops. But that seems to be very unlikely. Humans are social animals.